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Preservation of capital
Colin Deakins
Posted: 20 May 2017 21:14:17(UTC)
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[i]One message from Morningstar's seminar this week was that IFA clients are now prioritising the preservation of capital after a long period of capital growth in both bonds and equities. That sounds sensible to me.

Quotation from Micawber's post

I have a portfolio of equity funds which since 2008 have done reasonably well for funds. After considering the quotation from Micawber's post, I ask myself how do I go about preserving the capital I've accumulated.
2008/9 I sat back and hoped for the best, I don't think that strategy(?) will work over the next 10 years!

I realise the posters on this forum must do a considerable amount of research into buying and selling equities and IT's but I am at a stage in life when I may not see the gains if the Stockmarket does go down so any guidance on strategies for the preservation of capital will be most appreciated

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King Lodos
Posted: 20 May 2017 22:43:00(UTC)
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As one gets closer to the age they'll need money, it usually makes sense to shift to a more conservative asset allocation.

Burton Malkiel's recommendation (2015 edition of Random Walk Down Wall Street I believe) for over 60s – taking into account very expensive government bonds today:

http://i1381.photobucket.com/albums/ah215/nisiprius/2015-Malkiel-Random-Walk-Lifecycle-60s-small_zps60378a1d.jpg

But I would see it in terms of age and appropriate risk, rather than believing we're near a peak today .. I suppose the point of markets is the risk of capital loss is ALWAYS there – and sometimes you go many decades without it happening .. and if there was ever any certainty, the risk premium would quickly disappear.
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Mr Helpful
Posted: 21 May 2017 08:28:53(UTC)
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Colin Deakins;46958 wrote:
[i]One message from Morningstar's seminar this week was that IFA clients are now prioritising the preservation of capital after a long period of capital growth in both bonds and equities. That sounds sensible to me.

Quotation from Micawber's post

I have a portfolio of equity funds which since 2008 have done reasonably well for funds. After considering the quotation from Micawber's post, I ask myself how do I go about preserving the capital I've accumulated.
2008/9 I sat back and hoped for the best, I don't think that strategy(?) will work over the next 10 years!
........
........ but I am at a stage in life when I may not see the gains if the Stockmarket does go down so any guidance on strategies for the preservation of capital will be most appreciated




'IF'
the investor can live within the income provided by the 'natural yield' of their portfolio at all times, then capital fluctuations could be ignored !!!

In such a scenario Stock Price fluctuations could be welcomed as opportunities to buy lower and reduce higher, thereby reducing the book cost(s) of position(s) and increase the overall size of the portfolio.

This is a big 'IF' !!!
For many investors fluctuations in value can be gut wrenching.

The question would then change to how to preserve the income?

N.B. Investors in 1929 on, found their Stock Income collapsing.
Then only Gov't Bond Income held up.


One solution to the specific question asked, about "preservation of capital", is to have an Investment Plan that compares Asset Classs valuations and adjusts allocations based on those valuations (in a well diversified portfolio).
So when an Asset Class (e.g. Stocks) is deemed good value we load up, when deemed expensive we hold less.
This is termed a 'Variable Ratio Investment Formula Plan' versus the more often advocated 'Constant Ratio Investment Formula Plan'.

Capital fluctuations can never be eliminated, but may hopefully be reduced to sensible proportions by planning in advance.

A timely question.
Thank you for bringing to our attention.
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Money Spider
Posted: 21 May 2017 11:42:32(UTC)
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A great question and a topic I was pondering only yesterday. I see it as a multi-dimensional problem too. For example my/our assets are in different 'accounts' with different objectives (currently):
Uncrystallised SIPP: (aim to maximise tax-free cash, but watch further gov't restrictions). Crystallise tranches annually.
Crystalised SIPP: steady, good income with growth.
ISA: can be more adventurous, income for discipline, but income not necessary for life needs (yet).
Nominee account: income and growth, optimise CGT and income tax.
Cash: safe but very low returns.

So, one needs to manage these within an overall plan. There is also a thought that says "beyond amount £x, I am prepared to accept a lower return on a 'safer' type of investment". No one has yet mentioned investments like PNL(Personal Assets), RCP, Ruffer in this thread which are positioned as 'more cautious investments'. Any comments? I saw a useful one by Alan Selwood recently in the 'New Portfolio' thread.

I am interested to see how this thread develops, or at the end of the day is it just 'choose your asset allocation(s) in some percentage between cash, Bonds, Property and Equities?

Mr Helpful's comment re. Variable vs Fixed ratio allocation was good, but requires you to know where you are in the cycle, but I guess the whole point is that investing is subjective and 'hard', otherwise everyone would be making shed-loads of money!
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Stephen B.
Posted: 21 May 2017 12:21:02(UTC)
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I agree with Mr Helpful - it's rarely the case that preserving capital is in fact the priority, except perhaps as regards the psychological impact of losses. What you really care about is preserving income into the future. Also, the weight you place on different levels of income is not the same - there's some level you need to give you whatever you regard as a basic standard of living which is much more important to protect than spending on discretionary luxuries. For income you regard as absolutely necessary I think you need to bite the bullet and recognise that the current options, e.g. annuities, cash and gilts, are poor value but if you really want certainty you have to use them.

In my case I own my home outright and I have a pension (annuity in effect) in payment which covers my basic living costs. Beyond that I have essentially everything in equities and I don't expect that to change unless/until interest rates rise significantly. It's possible that my investment income could fall significantly, but it's unlikely to be enough to hurt my current standard of living, and if I tried to "protect" some of it by e.g. switching to gilts I would in fact just be guaranteeing a significant reduction in income rather than risking it.
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Mickey
Posted: 21 May 2017 15:18:54(UTC)
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Money Spider;46974 wrote:
...No one has yet mentioned investments like PNL(Personal Assets), RCP, Ruffer in this thread which are positioned as 'more cautious investments'....

I wrote a bit about this earlier but then cancelled my post thinking why would anyone be interested that I hold PNL and RCP :-)

Basically my portfolio is designed to preserve a decent balance of cash though not with a specific purpose other than we never had money as a family so now I like to keep some in the bank :-)

25% Cash
25% Personal Assets and RIT Capital Partners.
25% Global IT's
25% Themes/Ideas in IT's

Following significant market falls the PNL/RCP weighting is adjusted lower to take advantage of cheaper purchases such as IT's on decent discounts. As we later sell anything the PNL/RCP element is increased back to around 25%. If I like the market then RCP will be the dominant holder of the two, if I am more cautious then PNL takes over.

Holding such a percentage in PNL/RCP does limit growth but allows me to sleep soundly although PNL is quite a frustrating holding at times. I usually rebalance annually but not always, for example I would be unlikely to lower the cash holding if it where needed to boost the portfolio after a bad fall.
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Alan Selwood
Posted: 21 May 2017 15:37:10(UTC)
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To which you could add that it is after falls that PNL looks the most attractive : small rise plus smaller than average fall plus decent rise = better total result in may cases than big rise followed by big fall.

Of course, if you knew that the market was going to go down, you'd move to 100% in cash, then go 100% into a riskier equity sector ready for the maximum ride upwards again! (If only!!)
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King Lodos
Posted: 21 May 2017 16:33:33(UTC)
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Two things I'd not regard as fixed: that conservative portfolios limit growth, and that income is a real 'thing'.

This is one of the 'classics' – Harry Browne's Permanent Portfolio – with 25% each in Stocks, Long-term Bonds, Gold and Cash.

And this is over one of the best periods (80s and 90s) you could hope for for stocks .. And over nearly 40 years, the portfolio with only 25% in Stocks is ahead of the market .. More importantly, it was much more likely to get there (there are many more environments it would do well in).

http://2.bp.blogspot.com/_a9FNMR19fkk/SrBkUJVWenI/AAAAAAAAAKk/XPThnNcL3is/s1600/cumulative+comparison+perm+port+vs+TSM.PNG

On income, I'm with Terry Smith on this .. Income is just earnings the business isn't reinvesting in itself .. If instead the business were reinvesting that 5%, and attaining 5% additional growth, you could just sell 5% of your holding .. If a business is attaining a higher return on capital, then it's better they don't pay a large dividend.

I don't know quite why Preferred Shares aren't more popular (perhaps still nervousness about the banking sector), but here you can typically get much higher yields (over 7%), lower volatility, and income's guaranteed above dividends on common stock .. Buffett's a big fan.
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Money Spider
Posted: 21 May 2017 16:37:16(UTC)
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Mickey - yes, I'm interested (in PNL, RCP) :-)

Many investors, myself included hold a mix of Cash, Bonds, REITs and Equities for diversification/risk management/capital preservation.
Your allocation to (Cash + (PNL+RCP)) = 50%. So are you effectively using (PNL+RCP) as a substitute for individual bond and bond proxy holdings or are you also holding additional 'counterweights' in your IT's.

Given my comment above about portfolio diversification, is it thought better to a) continue such a strategy, but perhaps changing the weightings or b) add additional counterweighting with the likes of PNL, RCP etc?

I see the additional challenge when investments are held in a nominee account (outside SIPP or ISA) of the issue of not necessarily wanting to crystallise capital gains through selling/buying if one already has 'surplus' gains (above CGT allowance limits). I know tax 'tail' shouldn't wag the investment 'dog', but money is money and I don't like giving it to the tax man!
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Mickey
Posted: 21 May 2017 18:51:51(UTC)
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Money Spider;46986 wrote:
Your allocation to (Cash + (PNL+RCP)) = 50%. So are you effectively using (PNL+RCP) as a substitute for individual bond and bond proxy holdings or are you also holding additional 'counterweights' in your IT's.

Yes, I use PNL for its treasuries and gold whilst RCP is more for hedge funds etc. I don't have any bond holdings.
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Ark Welder
Posted: 21 May 2017 18:57:37(UTC)
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Whether captial preservation or income preservation is the priority depends upon individual circumstances - there can be very good reasons why the former is more important than the latter.

One example is where there is a large expense to be paid at some point, something that would need to be paid out of capital rather than income. Or the intention may be to bequeath the capital.

In my case, I wanted to maximise the 25% tax-free lump sum that could be taken upon crystallisation of my SIPP - an objective which came into being well before it became possible to split the tax-free element over subsequent withdrawals. In addition to the income-generating securities, I used a combination of PNL, RICA, BHMG, TPOG (although this proved to be too prone to voliatility and drawdown), zero-dividend preference shares which had appropriate redemption dates, and a progressively increasing chunk of cash. Different story post-crystallisation, though, as the purpose of the SIPP is now solely to generate an income (although there are residual holdings in PNL and RICA for now).

So my question to the OP would be to ask about the intended purpose of the capital? Or is the issue the psychological one of the thought of falls in prices - for which capital preservation is a valid approach, in my view, if it results in peace of mind.


King Lodos;46985 wrote:
I don't know quite why Preferred Shares aren't more popular (perhaps still nervousness about the banking sector), but here you can typically get much higher yields (over 7%)...

Not at today's prices. Yields on cost are generally lower than 7%, and lower than 6% in quite a few cases. Anything higher would suggest that there are traps for the unwary, e.g. the issuer has, er, issues, or there is a call date to be factored in and the yield to call is lower.
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King Lodos
Posted: 21 May 2017 19:10:21(UTC)
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Well today's prices may still be favourable against developed market stocks and bonds – which only forecast future returns around 2% .. and against unusually low cash rates and inflation, 5-6% on preferred shares or perpetuals may be almost decent.

Good piece on Philosophical Economics:

A Value Opportunity in Preferred Stocks
http://www.philosophicaleconomics.com/2017/03/a-value-opportunity-in-preferred-stocks/
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TJL
Posted: 21 May 2017 19:10:41(UTC)
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Welcome back Ark Welder.
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Money Spider
Posted: 21 May 2017 19:28:33(UTC)
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King Lodos,
I agree with you re, income being earnings that are not being invested.

Re. your graph, doesn't it depend upon the period over which you view it? Your graph runs to ~2008 when stocks are 'in the tank'. What does it look like if the x axis runs to, say, 2017, and the stocks line is smoothed? Are both lines still showing 'similar' returns? I'm not criticising - I'm learning (I hope)! ;-)
Stephen B.
Posted: 21 May 2017 19:55:37(UTC)
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For bonds any historical comparison is likely to be very misleading. For 30 years bond yields have been falling and hence capital values have been rising, and that isn't going to continue. At best bonds will continue to generate very low yields (zero or negative after inflation) with little change in capital value; more likely yields will start to rise and investors will take a capital loss. If equity markets had behaved similarly then share prices would also have risen and yields fallen, and we'd be facing a difficult situation where the only reasonable position was cash. However in practice equities are still at the same kind of valuations as in the 80s and 90s. I find it hard to imagine any scenario whatever in which long-dated gilts will do better than a diversified basket of shares over the next 30 years - if the economy were that catastrophically bad I doubt the government would be honouring its debts.
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Alan Selwood
Posted: 21 May 2017 20:39:26(UTC)
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TJL;46993 wrote:
Welcome back Ark Welder.


I second that!
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Stephen B.
Posted: 21 May 2017 20:45:38(UTC)
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Out of interest I just looked up the data on 30-year gilts. In 1981 the yield was 16% (so still paying that until 2011), in 1990 it was a bit below 12% (still paying that now), and at the low point last August it was 1.2%. So with an inflation target of 2% the government is basically promising you that it will lose you some money in real terms for the privilege of lending it money for 30 years ...
Alan Selwood
Posted: 21 May 2017 21:04:58(UTC)
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Stephen B.;46997 wrote:
For bonds any historical comparison is likely to be very misleading. For 30 years bond yields have been falling and hence capital values have been rising, and that isn't going to continue. At best bonds will continue to generate very low yields (zero or negative after inflation) with little change in capital value; more likely yields will start to rise and investors will take a capital loss. If equity markets had behaved similarly then share prices would also have risen and yields fallen, and we'd be facing a difficult situation where the only reasonable position was cash. However in practice equities are still at the same kind of valuations as in the 80s and 90s. I find it hard to imagine any scenario whatever in which long-dated gilts will do better than a diversified basket of shares over the next 30 years - if the economy were that catastrophically bad I doubt the government would be honouring its debts.


Over the period since approx 1986, inflation has been fairly benign, and that has allowed gilt yields to fall, because (all other things being equal) low inflation = low interest rates = capital gains from bonds. Government interference with both regulation of pension funds and QE has fuelled the fire and driven gilts to mega-high levels.

To see the other side of the coin, you could look at the 1970s, where (for example) 3.5% War Loan suffered from a period of torrid inflation, so that the market value of each £100 of stock fell from somewhere in the £80 to £90 area down to £17. Meanwhile, the real value after inflation had taken a nose dive of around 15% to 20% p.a. for 3 or 4 years or so.

The interest paid on the stock before the plunge, if priced at (say) £85 was (100/85 * 3.5) = £4.12 or 4.12% gross or (say) 3% net if the tax rate is 25%. If that fixed income arrives year by year during a time when inflation is (say) 16% p.a. you have real net interest of -13% p.a.

When the stock bottomed at £17 per £100 face value, you had also seen a decline in the capital of 80% in paper value, and after (say) 3 years at (say) 16% p.a. the real loss of capital at bottom was near infinite.

It is at that point that somebody known to somebody I worked with decided to BUY! (I wish it had been me)

At bottom, the gross interest on £17 market value of each £100 of stock was £3.50 = 20.6%.
Assume 25% tax, and you have net interest of 15.44%, guaranteed "for ever".

When the stock eventually recovered in capital value (paper value, not real value), and was redeemed in 2015, the tax-free maturity value had risen 5.88 times above the low point and the owner would also have received net income of (say) 15.44% p.a. from the late 1970s to 1995. Nice one!

Because the current scenario looks to me much more like the 1970 position than the 1980 position, I believe that bonds may be ruinous once the edifice crumbles because of the next round of high inflation and ultra-high interest rates, whenever that comes.
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Stephen B.
Posted: 21 May 2017 21:31:34(UTC)
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Yes, I agree entirely. I basically started as an investor in 1992 when I got a higher-paid job, and the first thing I did was buy 30-year index-linked gilts, then yielding I think a bit under 4%. However I decided I should learn about the stockmarket and the gilts fell by the wayside. I've never done the calculation but if I'd just kept putting everything in gilts I'd certainly have saved a lot of time and effort and might have come out ahead. On the other hand, by now I'd be completely stuck - and possibly coming here to ask people what to do next ...
King Lodos
Posted: 21 May 2017 22:20:21(UTC)
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Money Spider;46994 wrote:
King Lodos,
I agree with you re, income being earnings that are not being invested.

Re. your graph, doesn't it depend upon the period over which you view it? Your graph runs to ~2008 when stocks are 'in the tank'. What does it look like if the x axis runs to, say, 2017, and the stocks line is smoothed? Are both lines still showing 'similar' returns? I'm not criticising - I'm learning (I hope)! ;-)


Well it's as good as any backtest – which is to say: it ALWAYS depends on what period you're looking back over.

We had a bad period for stocks and bonds in the 70s, two good periods in the 80s and 90s, then a good period for bonds in the 00s.

So 75% of the time, that backtest was very good for bonds, 50% stocks, and 25% gold and commodities .. While stocks tend to do better over long periods (30+ years), over the medium term it may be fairly random which asset classes outperform .. So Harry Browne weights things 25% each .. The key point is that Harry Browne performs similarly no matter what's happening economically: inflation, deflation, growth, recession, etc. giving a much higher chance of a satisfactory outcome.
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